GDP Plays Mister Softee

After another record day, focus turns to third-quarter growth and Microsoft's earnings.
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You wouldn't know the economy is slowing to look at corporate earnings.

With about 278 companies in the

S&P 500

reporting, 76% have beat expectations, 12% have matched, and 13% have fallen short vs. the typical breakdown of 60/20/20, according to John Butters, analyst at Thomson Financial. If the season ends with 76% of company reports beating expectations, the third quarter would mark the highest number of blowouts in 10 years, he says.

The

oohs

and

ahhs

don't end here. Companies are beating expectations by 6.1%, much more than the historical average of 3.2%, says Butters. In recent quarters, companies have beat by about 5%. In all, earnings have grown 17% in the third quarter, much more than the 14% estimate before the reporting began, says Butters.

The earnings strength has helped push major averages higher from the summer lows and again on Thursday. The

Dow Jones Industrial Average

added 0.24% to make yet another new high closing at 12,163.66, while the S&P 500 gained 0.50%, closing at 1389.08. The

Nasdaq Composite

added 1% to close at 2379.10.

After the close Thursday,

Microsoft

(MSFT) - Get Report

beat expectations for fiscal first-quarter earnings and revenue growth, but gave lower-than-expected earnings guidance. The company's shares were trading near their 52-week high of $28.70 during Thursday's trading session, but were recently down 0.18% in after-hours trading.

Broadly, the technology sector has pleasantly surprised analysts, recording 9% year-over- year earnings growth vs. estimates for a 5% growth rate. Tech companies have beat estimates by a whopping 10%, compared with the 6.1% besting in the broad market. Some standouts have included

Intel

(INTC) - Get Report

and

Apple

(AAPL) - Get Report

, which both beat expectations by 22%. Both companies' shares have been gaining ground lately, trading at the upper end of their 52-week ranges.

On Thursday,

LSI Logic

(LSI) - Get Report

jumped 14% after the chip designer posted better-than-expected third-quarter results.

Outside of the technology sector, a barrage of strong earnings reports, falling crude prices and tame economic news boosted the broader market Thursday. Earnings included reports from

Exxon Mobil

(XOM) - Get Report

,

Aetna

(AET)

,

Bunge

(BG) - Get Report

,

Comcast

(CMCSA) - Get Report

,

OfficeMax

(OMX)

, and

Kellogg

(K) - Get Report

, among others.

Friday brings the first estimate of third-quarter gross domestic product. Once upon a time, one could look to GDP for signs of how profitable U.S. companies might be. But that relationship has broken down, says Moody's Investors Service chief economist John Lonski.

Rising Profits, Slowing Growth

The more U.S. companies produce overseas goods for consumption in the U.S., the more the high trade deficit correlates with greater profitability, and not the other way around, says Lonski, who estimates the economy grew 2.4% in the third quarter. "GDP is increasingly a measure of social welfare, not corporate health."

By social welfare, Lonski means domestic demand and the health of the consumer. By most measures, consumers are doing well amid low unemployment levels and rising wages, despite the deflating housing market.

Most economists expect third-quarter GDP to decline from the second quarter's 2.6% pace, with consensus estimates putting growth at 2.1%. Estimates range from Goldman Sachs' 1% to Bear Stearns' 3%.

"The discrepancy arises from assessing the degree of decline in housing," says Peter Kretzmer, senior economist at Banc of America Securities who estimates GDP grew at a 1.3% pace.

Economists are working estimates from monthly construction numbers, and they make several assumptions to annualize those numbers, says Kretzmer. Even so, most economists agree that the main drag on GDP in the third quarter is residential-investment spending, a.k.a. housing, which comprises about 5% of GDP. Kretzmer believes residential investment spending fell 20% in the third quarter, with other drags including declining inventories, or slower manufacturing growth, and lower levels of net exports. Lonski says housing lops off about 1% to third-quarter GDP and says the trade deficit is the second-biggest drag on GDP for the quarter.

Most of the data points to acceleration in the fourth quarter of 2006, says Morgan Stanley economist Richard Berner, who expects 1.8% third-quarter GDP growth.

Kretzmer agrees. A decline in U.S. manufacturing in the third quarter sets up for a stronger fourth quarter and a resurgence of inventories. Likewise, the housing market is muddling through and has recently shown some signs of a bottom, he says. Capital spending is a wildcard, though, as second-quarter capital spending was surprisingly weak at 4.4%. (In Thursday's other economic news, the Commerce Department reported a jump of 7.8% in durable-goods orders in September, beating forecasts of a 2.3% increase. But excluding transportation, durable-goods orders rose just 0.1%.)

Thursday's report of new-home sales is arguably one of those signs of a housing bottom. It showed a second consecutive increase of new homes sold in September, rising 5.3%, and marked a 9.2% two-month gain. Prices are still plummeting, however. The median new-home price fell 9.7% on a year-over-year basis in September, the largest drop since 1970. Yet, countering the price declines was a drop in inventory to 6.4 months from 6.8 months.

Deutsche Bank's economists agree that the bottom is near, noting late Thursday that low mortgage rates, lower prices, sideways growth in mortgage applications and rising incomes are turning around the residential real estate market. Deutsche Bank forecasts third-quarter GDP growth at 1.5%.

"The impact from a bottoming in housing market activity is likely to feed through to home price inflation over the coming quarters, implying that prices will stay roughly flat or close to current low-single-digit negative year-over-year rates," writes Peter Hooper, chief economist at Deutsche Bank, adding that the peak of housing's negative impact on GDP growth comes in the second half of this year.

So as profits soared, growth slumped -- go figure.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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